Here’s Paul Krugman on Finland:
Why can’t Finland recover this time? Debt is not a problem; borrowing costs are very low. But it’s all about the euro straitjacket. In 1990 the country could and did devalue, achieving a rapid gain in competitiveness. This time not, so that there is no quick way to adjust to adverse shocks:
This shouldn’t come as a surprise; it’s the core of the classic Milton Friedman argument for flexible exchange rates, and in turn for the tradeoff at the core of optimum currency area theory. The trouble in Finland is what everyone expected to go wrong with the euro.
What’s going on in Greece represents a whole additional level of hurt, which nobody saw coming. But it’s important, I think, to realize that even countries that didn’t borrow a lot, didn’t experience large capital inflows, basically did nothing wrong by the official criteria, are nonetheless suffering in a major way.
Krugman’s right that for the most part (excluding Greece) the euro is failing in exactly the way people like Krugman and Friedman expected it to fail.
Here’s an interesting Krugman observation on Grexit:
But the bigger question is what happens a year or two after Grexit, where the real risk to the euro is not that Greece will fail but that it will succeed. Suppose that a greatly devalued new drachma brings a flood of British beer-drinkers to the Ionian Sea, and Greece starts to recover. This would greatly encourage challengers to austerity and internal devaluation elsewhere.
This is the problem the gold bloc faced after Britain left gold in 1931. I have a similar view, although I’m a bit less worried about Greece leaving the euro than Krugman, but partly because I think an “experiment” would be useful. Unfortunately the new Greek government is so incompetent I’m not even sure that devaluation would help, but it’s worth a shot. (Just to be clear, at this late date I believe Greece would be much better off doing structural reforms and staying within the euro.)
Here’s Krugman (implicitly) discussing the never reason from a price change problem:
In the left panel, you see the Fed funds rate seesawing as the Fed tried to grapple with inflation — and you see housing starts move strongly in the opposite direction, plunging when rates rose and soaring when they fell. In the right panel, however, you see housing starts and interest rates moving in the same direction — plunging together. So is there no relationship?
Bad answer. The situations are different in a fundamental way. In the 80s interest rates were being driven by fear of inflation; from the point of view of the housing market, they were more or less endogenous. In the post-2006 period they were being driven largely by the housing bust itself. So the 80s experience was a sort of natural experiment in the effects of rate changes, whereas more recent events are an illustration of reverse causation.
And I’ve been arguing for a long time that there was a regime shift in the late 1980s, that as inflation fears were replaced by the Great Moderation, we entered an era of postmodern recessions in which monetary policy was trying to clean up after bubbles rather than curb inflation.
The point, then, is that when you look for the effects of monetary policy, it’s often important to distinguish between eras when interest rates are a cause and eras when they’re an effect — and it’s not that hard to know which eras we’re talking about.
My only quibble is that instead of saying it’s only OK to reason from a price change in certain occasions, I prefer saying never reason from a price change—always reason from the thing that caused the price to change (such as tight money in 1981.) Tight money depressed housing in 1981, no need to even mention interest rates.
PS. I have a new post on current Fed policy over at Econlog.